The Maturing of a Market

2013 will determine whether the Russian financial market becomes an organised and responsible member of the global economic community.

This has been an odd year for investors.
The market has ultimately managed healthy gains, and bonds have performed well.
But even so, old Russia hands are probably disappointed. After so many years of
astounding out-performance, both up and down, 2012 stands out as the year in
which the Russian equity market reached adulthood. No more adrenaline rushes as
the MICEX turned 20 and promptly entered corporate matrimony with the younger,
but more future-oriented, RTS. What will happen next in this exciting epic of
economic evolution?

Russia has put its go-go teenage years
behind it. Annualised index volatility has slumped to 19 percent, the lowest on
record, and 2012 returns will ultimately disappoint many accustomed to fast and
easy money. Investors need to accept that a new level of maturity will be
required to negotiate the market's challenging third decade of existence. There
is good news though. The Russian financial sector is on course to mature into a
respectable and productive young adult, efficiently intermediating between
investors and companies with a wide range of interests. Despite some impressive
developments in 2012, the high and rising equity risk premium tells us that
there is plenty more exciting work ahead.

Technically, the RTS and the MICEX
finalised their merger in 2011, but the integration took place only this year,
culminating in the upcoming adjustment of the MICEX Index to include the same
50 names as the RTS. At last, Russia will have real volume trading in an index
that is investable and reflects more than just the biggest blue chips. The formation
of a central depository was an equally important event. But the infrastructure
development of greatest importance is surely the subsequent opening of the
rouble debt market to international investors. By early 2013, global investors
will have easy access to a diverse array of locally traded rouble bonds. This
development will bring immediate benefits to corporations, Russia's capital
account and the global investor community. It may also rapidly have the
knock-on affect of improving corporate governance and regulation. Managers
should quickly notice that the best-behaved companies borrow at the best rates.

Elsewhere, the government won accolades for
the decision to reinstate budget constraints against fiscal largesse, talked
tough on corruption, implemented impressive dividend policies and defined
ambitious modernisation plans with clear milestones to allow independent
monitoring of progress. The Central Bank also rose to the occasion, pursuing
the path to inflation-targeting and playing a considerable role in one of the
rouble's most stable years to date. The country's top billionaires, too,
contributed, with concerted efforts to resolve several long-standing conflicts.
Not least, the end of the TNK-BP saga lifts a substantial blight overshadowing
the whole equity market, and the signs are good that Norilsk Nickel will pursue
a clear and profit-oriented strategy going forward. Let's also not forget that
Russia finally joined the World Trade Organization in late August.

If all appears to be well and good, why is
the equity risk premium rising, and why is Russia's discount to its peers so
high? The answer to both these questions can be found in the difficult
transition from communist superpower to modern capitalist state. The government
is talking the talk, but next year more than ever it will need to walk the
walk.

At the top of the list, countries need a
fair, independent judicial system to enjoy low costs of capital and sustainable
global capital inflows. What's more, one-party systems always make investors
nervous about long-term projects.

But perhaps the most urgent item on the
list is the need for a cogent macroeconomic policy. It doesn't only define the
path forward, it is also essential for consolidating the progress already
achieved. The government has correctly acknowledged that the old economic model
is broken. Despite the probability of healthy global growth in 2013, Russia
runs the risk of missing the party. Commodities prices are unlikely to rise
like they did in the pre-crisis era, and Russia remains a resource-dependent
economy. Slower retail sector expansion this year, coupled with soaring
household borrowing, should raise concerns. Next year's growth will come from
investment or nothing.

It is true that for the time being, the
government can provide the capital that the private sector is so nervous about
deploying, especially as returns on investment appear to be declining while
risk lingers at an elevated level. But this is not a sustainable solution.
First, the state sector is already far too large and is struggling to shrink
itself. Second, the government is notoriously bad at economically efficient
capital allocation. Third, the state simply lacks the funds to keep funding
huge projects year after year. Government projects might get the ball rolling,
but for Russia to resume healthy growth it is going to need to meet its
qualitative development milestones. That will require the bureaucratic elite to
do more than just talk the talk.

Russia's financial market is growing up
fast before our eyes. But 2013 will determine whether it becomes an organized
and responsible member of the global economic community, or whether at this
sensitive young age it becomes easily distracted and runs off the rails. We all
have a responsibility to play our part in stewarding it to a successful middle
age.

James Beadle, who has 12 years experience dealing with
the Russian market, is a senior investment adviser at Societe Generale Private
Banking, Monaco.